Blockchain in Capital Markets…Cost savings a plenty, but there is so much more to the story

While market experts weigh in on the likelihood and impact of the next recession, here are my thoughts on the impact Blockchain and Distributed Ledger Technologies will have on Capital Markets in the short to medium term.

2019 has been called the year of Security Token Offerings (STOs). The benefits of Security tokens becoming the store of value for things like real estate, private companies, startup cohorts and other illiquid assets are undoubtedly immense. STOs offer frictionless entry and exit of holdings, real time compliance, cap table management and superior corporate governance. Let’s look at the numbers to estimate how “Tokenization” can transform the more liquid, deeper, and already more efficient bond and equity markets.

1. Sales and Trading Costs for Investment Banks (IB)

Information silos rampant in IB today cause routine operations such as KYC/AML checks, client onboarding, trade reconciliation and dispute resolution to require manual, multi-step processes and specialized internal teams. Every Financial Institution (FI)is forced to keep their own book of record due to the lack of a “single source of truth”. According to Autonomous Research’s Fintech report, Global Sales and Trading activity costs were $160bn annually in 2016, of which $54bn was spent on Post Trade Operations, Custody, Financing, Record keeping, Regulatory reporting, etc., clubbed loosely together as “Back Office” tasks. The report estimates that Blockchain could save up to $16bn or 30% of these costs by 2021. To put this in the context of revenues, this industry has a $200bn revenue pool, contracting 3.5% yearly in the last decade. These cost savings create a value uplift of 10% of implied market valuations of the top 9 IB players.

These 3 areas in this title might seem out of place together but consider this: As Blockchain reduces Trade Settlement times of Financial instruments from T+2 or 3 (or T+20 in the case of Syndicate Loans, and T+months in the case of some esoteric products) to zero, Banks no longer need to hold capital to provision for counterparty risk due to settlement times. This is estimated to free up $6bn of capital, or 5% of existing capital held against Risk Weighted Assets which can go toward increasing liquidity in markets. As the need for intermediation reduces, the model will gradually shift towards an all-to-all network which improves supply and demand matching.

The lack of trust and transparency among market participants has caused a proliferation of custodial services and intermediaries. In a world with over $300trn of Global financial assets, it is no surprise that the market cap of the top 7 Custodians are $275bn. In Oliver Wyman’s report, asset servicing, treasury, payments, clearing and settlement operations are vulnerable to disintermediation, representing over $75bn in market capitalization. Smart contracts can create autonomous execution of complex financial agreements in a shared trusted environment. The Custodian Services’ fee based revenue pool of $40bn is at risk.

4. Compliance and Fraud Minimization

In the last decade, an increase in regulations have caused a proportional increase in compliance costs. It is estimated that banks spent $100bn in compliance costs in 2016 and this cost is poised to rise from 4% to 10% of revenues by 2021. In Sales and Trading, audits of client fees linked to a trade are done weeks or months after trade execution, making it particularly onerous for trading desks to reconcile and comply. Bringing the Regulators on chain can transform the way compliance is conducted within regulated entities. Smart contracts can offer immutable transactional data with the granularity needed for regulators to monitor FIs on-demand and in real time.

Taking the conversation beyond costs

As a former Structurer of Fixed Income products at JP Morgan, I’m particularly excited to extend the conversation beyond cost savings to potential new utility.

Consider the following use case:

Network 1 is designed to streamline the process of originating loans. Mortgage players and originators are participants in this network.

Network 2: The loan moves to network 2 which securitizes loan pools to create tranches with different ratings. Rating agencies and 3rd party validators are one of the participants in this network.

Network 3: A 3rd network could represent a consortium of investors who have undergone KYC/AML checks.

The investor in Network 3 can access the loan in Network 1 and could find utility for it in a 4th, yet-to-exist-today Network. An Asset Back Security in digital security format will have provenance and can create new user behavior giving birth to a new generation of financial instruments.

Future Generation Blockchain: 3 Networks with different utilities interact together to create new user behavior

Credit to IBM’s Ant Cole for this illustration above of how a Network of Networks outside of Capital Markets can look like, and thanks to Andy Martin for highlighting.

Building out the infrastructure for on-chain trading activities will not be a winner-take-all phenomenon. Nimble startups are partnering with industry participants and consortia to solve the typical Blockchain solvable problems for individual use cases. Several private, permissioned networks, and interoperability standards will create a “Network of Networks” This will bring about new utility and new user behavior in the ecosystem.

What do you think of the cost savings estimates in this article?Thoughts/comments? Reach me on Medium, Twitter or Linkedin